Professional Documents
Culture Documents
Volume 9 Number 1
Spring 1996
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We could accomplish the same effect by deflating C* using the price index, and then discounting using the real rate of
interest: This would give:
Equation 4
PV = (C* / (1 + p)t) / (1 + k)t
Since equations (3) and (4) both furnish the same results, they can be set equal to one another thus:
Equation 5
C * / (1 + p)t
( 1 + k )t
C*
( 1 + i )t
TABLE 1
The Real Rate Of Interest As Deflated By The CPI
Year
AAA Rate
CPI Change
Real Rate
Year
1976
1977
1978
1979
1980
1981
1982
1983
1984
8.42
8.02
8.73
9.63
11.94
14.71
13.79
12.04
12.71
3.7
6.9
9.0
13.3
12.5
8.9
3.8
3.8
3.9
4.72
1.12
-.27
-3.67
-.56
5.81
9.99
8.24
8.81
1985
1986
1987
1988
1989
1990
1991
1992
1993
AAA Rate
11.37
9.02
9.38
9.71
9.26
9.32
8.77
8.14
7.22
CPI Change
Real Rate
3.8
1.1
4.4
4.4
4.6
6.1
3.1
2.9
2.7
7.57
7.92
4.98
5.31
4.66
3.22
5.67
5.24
4.52
Source: Economic Indicators Joint Economic Committee, July, 1982, pp. 13, 24; May 1990 pp. 24, 30; March 1994 pp. 26, 30.
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As can be seen from Table 1, one cannot expect to compute the real rates of interest on an ex post basis by deflating the
nominal rate of interest by a price index. However, this does not mean that one cannot use the current rate of interest as an
ex ante measure of the real rate plus expected rate of inflation. The ex post analysis will fail because current inflation rates
are not necessarily the expected future rate and because monetary policy may well distort interest rates for a short period of
time.
Generally accepted economic theory supports the conclusion that the rate of interest should move in the same direction
as the expected rate of inflation. A pure quantity theory of money approach would argue for almost exact movement.
Under the loanable funds theory, the demand for money should increase because of (1) increased transactions demand and
(2) increased precautionary demand while the supply of loanable funds would decrease as surplus spending units reduced
their excess balances. Both these actions would force up the cost of money.
Under the liquidity preference theory, the demand for funds would increase for the above reason, and for the reason
that investors would expect a fall in bond prices as a result of the inflation and would thus tend to want to hold money
balances. Theory would then predict rising interest rates as the expectation of higher inflation occurred. On any type of
expectations theory approach, the rate of interest should increase with an increase in the expected rate of inflation.
The empirical evidence with respect to whether or not interest rates would perfectly reflect expected inflation is strong
but also controversial. Fama6 demonstrates that short term rates accurately reflect the expectations of future rates of
inflation [7], but his methodology and conclusions have been disputed by several rebuttals, [5, 8, 13]. Cagan and Goldolfi
have achieved similar results for long term rates [4], although they argue the results might not be applicable to short term
rates.
Finally, the question arises as to the movement of the cost of capital when inflation occurs. We have shown that it is
reasonable to expect that the rate of interest will increase when there are expectations of higher inflation, but there appears
to be little evidence on the measurement of the cost of capital under inflationary expectations. This is understandable,
given the difficulty in just measuring the cost of capital in a static sense.
Our assumption in the following analysis that the cost of capital on an ex ante basis increases with the same proportion
as the expected rate of inflation; that is, the same mechanism which causes interest rates to rise during inflation will also
cause the cost of capital to rise. Furthermore, those who provide equity capital are likely to behave in the same manner as
those who provide debt capital.
Short term phenomena may prevent the cost of capital from behaving precisely in this fashion. One action may be for
business to alter capital structure, moving towards greater amounts of debt and thus lowering the after tax cost of capital.
However, these corrections are not long term and in the case of rising debt costs should have little impact on the overall
movement of the cost of capital from rising proportionately with expected inflation, but this too should not prevent a long
term assumption that cost of capital does increase when the expected rate of inflation increases.
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Equation 8
I 0 + WC0 =
WC 0
(Ri Ci )( 1 t )
Di t
+
+
( 1 + r )i
(1 + r )i
(1 + r )n
where:
I0
WC0
t
r
The term WC0 is not defined in the traditional sense of net working capital being current assets minus current
liabilities. Current liabilities in the accounting sense contain short term debt. For capital budgeting decisions net working
capital must be defined as current assets minus nondebt current liabilities, for only in that definition does it represent the
amount of financing that must come from traditional sources of debt and equity.
This type of investment in net working capital is important in understanding the dynamics of capital budgeting
because it represents a non-depreciable asset. The cost to the firm is the time value of money, and it is salvaged at the end
of the period as represented by the last term in equation (8). It is, as we shall see, a vitally important concept when
inflation is introduced into the process.
If we introduce inflation here, and assume that the cost of capital perfectly reflects the inflation assumption, as do
revenues and costs, equation (8) becomes as follows:
Equation 9
( Ri Ci )( 1 + f )i 1( 1 t )
Di t
+
I 0 + WC0 =
1
i
i
i
(1 + r ) (1 + f )
( 1 + r ) ( 1 + f )i 1
WC1
WC0 + WCi
+
i
i-1
(1 + r) (1 + f)
(1 + r)n (1 + f)n-1
The appearance of the new term in equation (9), WCi, represents the increase in net working capital each year as a result
of the inflation. If current assets of a company are $10 million, and current liabilities excluding debt are $5 million, then a
10% increase in these prices will increase both current assets and current liabilities by 10%. Current assets would rise by
$1 million, but current liabilities would rise by only $500,000, leaving, in this case, $500,000 financed. This additional
financing requirement must be included in the capital budgeting decision making process, or else the net cash flow and
net present value are overstated. The additions to net working capital and the initial net working capital is recovered at the
end of the projects, as shown in the last term.
An important result of comparing equation (9) with equation (8) is that with respect to the right hand side of equation
(9), which represents the present value of the cash inflows after inflation, those values are less than the right side of
equation (8). This is to say, inflation reduces the present value of the cash inflows from any given project. There are two
reasons why this reduction in value takes place. The first is that the cash flow from depreciation is reduced on a present
value basis, since the nominal cash flow from depreciation is unchanged while the discount rate rises due to the inflation.
The second reason for the decline in the present value of the cash flows is the appearance of net working capital and its
increased requirements during the life of the project. Although these outflows are recovered, the time value of money
reduces the present value of the entire stream.
In effect, the introduction of inflation into equation (8) negates the analysis of Rappaport and Taggart in their
conclusion in which they state that:
a rule of thumb that may help to combine the administrative simplicity of the gross profit approach with the
theoretical advantages of the nominal cash flow approach is to make the simplifying assumption, when
appropriate, of a constant ratio of Rt - Ct to Rt over time ... This is equivalent to assuming that revenues and costs
increase at the same rate over time [14, p.12]
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The impact of inflation as shown in equation (9) says that this is not likely to happen. Managers could only accept equal
increases if they were willing to lower the amount of profit acceptable from a capital project. And at the margin, the
introduction of inflation would cause the project to be rejected. Rappaport and Taggart do state that there is no
requirement that this rate be the economy wide inflation rate, but for most firms one would expect that the rate to be
reasonable approximation of the case for the cost side of the equation. Thus inflation of revenues must tend to be larger
than inflation of costs if the NPV is to remain the same.
At this point consider the following example. In Table 2, data is given for two nearly identical projects, A and B,
whose only difference is in the type of investment required. A requires $200,000 and B requires $200,000 but As
investment is in net working capital while Bs is in depreciable plant and equipment.
TABLE 2
Summary Of Project Data
Project A
Project B
Tax Rate
.45
.45
Quantity
1000 units
1000 units
$250
$250
Discount Rate
3%
3%
Inflation Rate
$200,000
$200,000
Years
If equation (8) is used to solve for the missing variable, the price of the project necessary to justify the undertaking of the
investment, that is the price at which the NPV is zero, then for case A and B the price is as follows:
Case A: $260.91
Case B: $296.67
The higher price in Case B is the result of the fact that only 45% of investment costs are recovered through the tax shield
from depreciation, whereas 100% of the net working capital is recovered. It is true that the depreciation is recovered faster,
but at a low discount rate this faster recovery is not sufficient to overcome the loss of 55% of the initial investment on a
cash basis.
The results above are for a world with zero inflation. If we introduce inflationary expectation of a steady rate, say 12%
into the system, the results would be to increase both costs and the discount rate. If we assume that the relationship
between inflation and the discount rate is as previously described, 12% inflation would produce a 15.36% discount rate. If
we increase the product price by the amount of the expected rate of inflation, and test for NPV we find the following
results:
NPV
Case A
Case B
($101,637)
($ 33,302)
The substantially lower NPV for Case A reflects the problems caused by the presence of net working capital during
periods of inflation. In this case the inflation causes an addition to the net working capital each year, and the additions are
cash outflows which are not recovered until the end of the project. The cash opportunity cost is high, because the discount
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rate is high which is elevated due to high inflation. In case 2, the only effect was to reduce the tax flow from the
depreciation shield. Thus if prices only kept pace with inflation, both projects are unacceptable, but the project with the
higher net working capital is more unacceptable.
The degree to which prices must increase to bring the investment back to an acceptable level can be computed. For
each case the results are as follows:
Case A
Case B
22.3%
15.9%
Case A, with its net working capital, requires almost a doubling of the rate of cost inflation in order to keep the companys
project profitability unchanged, while Case B requires only a slightly higher than inflation price increase.
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REFERENCES
[1] Andres D. Baily, Jr. and Daniel L. Jensen, General Price Level Adjustments in the Capital Budgeting Decision,
Financial Management, Spring 1977, pp. 26-32.
[2] Peter L. Berstein, The Gibson Paradox Revisited, The Financial Review, September 1982, pp. 153-164.
[3] P. Bjerksund and Steinar Ekern, Managing Investment Opportunities Under Price Uncertainty: From Last Change
to Wait and See Stregies, Financial Management, Autumn, 1990, pp. 65-83.
[4] P. Cagan and A. Gandolfi, The Lag in Monetary Policy as Implied by the Time Pattern of Monetary Effects on
Interest Rates, American Economic Review, May, 1969.
[5] John A. Carlson, Short Term Interest Rates as Predictors of Inflation: A Comment, American Economic Review,
June, 1977, pp. 469-475.
[6] Phillip L. Cooley, Rodney L. Roenfeldt, and It-Keong Chew, Capital Budgeting Procedures Under Inflation,
Financial Management, Winter 1975, pp. 12-17.
[7] Eugene F. Fama, Short Term Interest Rates as Predictors of Inflation, American Economic Review, June, 1975,
pp. 269-282.
[8] Douglas Joines, Short Term Interest Rates as Predictors of Inflation: A Comment, American Economic Review,
June 1977, pp. 476-77.
[9] David S. Kidwell and Richard L. Peterson, Financial Institutions, Markets, And Money, Hinsdale, Illinois, The
Dryden Press, 1981.
[10] Nalin Kulatilaka and Alan J. Marcus, Project Valuation under Uncertainty: When Does DCF Fail, Journal Of
Applied Corporate Finance, Fall 1992, pp. 92-100.
[11] Edward Miller, Safety Margins and Capital Budgeting Criteria, Managerial Finance, Number 2/3, 1988, pp. 1-8.
[12] Charles R. Nelson, Inflation and Capital Budgeting, Journal Of Finance, June, 1976, pp. 923-931.
[13] Charles R. Nelson and G. William Schwert, On Testing the Hypothesis that the Real Rate of Interest is Constant,
American Economic Review, June 1977, pp. 478-486.
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[14] Alfred Rappaport and Robert A. Taggart, Jr., Evaluation of Capital Expenditure Proposals Under Inflation,
Financial Management, Spring 1982, pp. 5-13.
[15] A. Shapiro, Optimal Inventory and Credit Granting Strategies under Inflation and Devaluation, Journal Of
Financial And Quantitative Analysis, January 1973, pp. 37-46.
[16] James C. Van Horne, A Note on Biases in Capital Budgeting Introduced by Inflation, Journal Of Financial And
Quantitative Analysis, March 1971, pp. 653-658.
[17] John C. Woods and Maury R. Randall, The Net Present Value of Future Investment Opportunities: Its Impact on
Shareholder Wealth and Implications for Capital Budgeting Theory, Financial Management, Summer 1989, pp.
85-92.